Date: 15/04/2010

URL: http://www.thehindubusinessline.com/2010/04/15/stories/2010041550200700.htm

Mischief potential of sweat equity

The only occasion when allotment of shares for non-cash consideration does not raise eyebrows is
when bonus shares are issued democratically to all the shareholders ratably.
The possibilities to indulge in clandestine deals are endless.

S. Murlidharan

Sweat equity is not purely a product of a novelist's fecund imagination. Indeed, sweat equity is
issued by companies both for noble and ignoble purposes though to an average mind there is always
a sinister ring to it — it is issued to buy silence or patronage.

In India, sweat equity had not hogged headlines until l'affaire Shashi Tharoor and the Kochi cricket
team broke out. That what has been allotted to Ms Sunanda Pushkar, perceived to be close to the
Minister of State for External Affairs Shashi Tharoor, by the owners of the Kochi team is sweat
equity has set tongues wagging and wags looking into the issue with a new interest.

CONTROVERSY PRONE

The purpose of this article however is not to get mired in the latest controversy involving the enfant
terrible of the Congress party but to examine afresh the wisdom of allowing sweat equity shares to be
issued.

Section 79A of the Companies Act, 1956 inserted in 1999 defines ‘sweat equity shares' to mean
“equity shares issued by the company to employees or directors at a discount or for consideration
other than cash for providing knowhow or making available right in the nature of intellectual
property rights or value additions, by whatever name called.”

The only occasion when allotment of shares for non-cash consideration does not raise eyebrows
though it may set in motion an academic debate is when bonus shares are issued democratically to all
the shareholders ratably. Issue of shares in return for a machine supplied always bristles with
controversies as to the true value of shares, especially when the shares happen to be unlisted.

And when they are issued for supply of technology or intellectual property, it raises the eyebrows
several notches higher what with both — shares and intellectual properties — being unknown
quantities, defying proper valuations and amenable to manipulations.

To be sure, it is common for suppliers to double in as promoters-cum-dominant shareholders. One

cannot have any serious objection to this arrangement so long as they bring cash up-front for shares
allotted to them. Shares as consideration for supply of goods and services however bring in avoidable
problems. Some newspapers themselves have been put in the doghouse for receiving shares in lieu of
editorial space. Apart from posing valuation problems, trifling with share capital has another
ramification — dilution in the intrinsic value of shares with increase in the number of outstanding
shares.

Share capital of a listed company in particular is too sacrosanct to be tinkered with on a day-to-day
basis.
PRINCIPLE DILUTED

The company law indeed grants this when it makes the rights issue the norm — the existing
shareholders have the first right of refusal when the share capital is sought to be increased.
Unfortunately, this salutary and solemn principle is considerably diluted by the law itself by carving
out exceptions — preferential allotment and private placement.

Ideally, anyone aspiring for a listed company's shares must gain entry through the market or a private
deal without involving the company. Shortcuts such as preferential allotment, private placement,
allotment to suppliers, etc., for non-cash consideration bristle with ethical and valuation problems.

It would be more transparent and ethical if a promoter bringing technology to the table is paid cash
for his services by the company instead of being rewarded through allotment of shares.

It is not as if the value of the technology brought in cannot be exaggerated in an all-cash deal but at
least the sleight of hand would not impact on the share capital of the company. The only exception
that can possibly be made is in favour of employees.

AMENDMENT NEEDED

The mischief potential of Section 79A has dawned on the media in the wake of l'affaire Kochi cricket
team and will transmit itself to the public soon. Bribes can be camouflaged as shares, favours can be
returned through allotment of shares and one's silence can be bought with allotment of shares. The
possibilities are endless and excite as much the novelists as they do the people involved in a
clandestine deal.

Section 79A therefore needs to be amended so that sweat equity is meant only for those who sweat it
out for the company. All others sweating it out for themselves or otherwise ought to pay
transparently for the shares upfront.

There is a view that making a supplier a shareholder brings about synergy — he is likely to supply at
the right price, at the right time and in right quantities of right quality. But this can be achieved
without tinkering with the share capital of the company. Let him acquire shares of the company
transparently either from the market or from the promoters in a private deal without involving the
company and disturbing its capital structure.

(The author is a Delhi-based chartered accountant.)

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 Checklist for the Issue of Sweat Equity Shares for Unlisted Companies
[Section 79A and Unlisted Companies (Sweat Equity Shares) Rules, 2003]

Pre Requirement

1. At least one year has elapsed since the date of Commencement of Business by Company
before issue of Sweat equity shares.

2. The company shall not issue sweat equity shares for more than 15% of total paid up equity
share capital in a year or shares of the value of 5 crores of rupees, whichever is higher except
with the prior approval of the Central Government in Form 65

3. Sweat Equity shares are shares only of a class already issued by the Company

Other Provisions

4. Call Board Meeting for calling EGM for the issue of Sweat Equity Shares

5. The Explanatory Statement should include the following details:

(i) the date of the meeting at which the proposal for issue of sweat equity shares was
approved by the Board of Directors of the company;

(ii) the reasons/justification for the issue;

(iii) the number of shares, consideration for such shares and the class or classes of
persons to whom such equity shares are to be issued;

(iv) the value of the sweat equity shares alongwith valuation report/ basis of valuation
and the price at the which the sweat equity shares will be issued;

(v) the names of persons to whom the equity will be issued and the person's
relationship with the company;

(vi) ceiling on managerial remuneration, if any, which will be affected by issuance of

such equity;

(vii) a statement to the effect that the company shall conform to the accounting policies
specified by the Central Government; and

(viii) diluted earning per share pursuant to the issue of securities to be calculated in
accordance with the Accounting Standards specified by the Institute of Chartered
Accountants of India.

6. If, Shares are issued at Discount than approval of Central Government need to be taken as per
Section 79.
7. Approval of shareholders by way of separate resolution in the general meeting shall be
obtained by the company in case of grant of shares to identified employees and promoters,
during any one year, equal to or exceeding 1% of the issued capital (excluding outstanding
warrants and conversion) of the company at the time of grant of the sweat equity shares.

8. Get approval of Members by passing Special Resolution stating the following details:
a. No. of Shares
b. Current Market Price
c. Consideration
d. Classes of Directors or employees to whom the equity shares will be issued
(employee includes Executive Director)

9. The Board of Directors, shall, inter alia, disclose either in the Directors' Report or in the
annexure to the Director's Report, the following details of issue of sweat equity shares :-
a. Number of shares to be issued to the employees or the directors;
b. conditions for issue of sweat equity shares;
c. the pricing formula;
d. the total number of shares arising as a result of issue of sweat equity shares;
e. money realized or benefit accrued to the company from the issue of sweat equity
shares;
f. Diluted Earnings per Share (EPS) pursuant to issuance of sweat equity shares.

10. Pricing of Sweat Equity Shares: The price of sweat equity shares to be issued to employees
and directors shall be at a fair price calculated by an independent valuer.

11. Lock-in of sweat equity shares: Sweat equity shares issued to employees or directors shall be
locked in for a period of three years from the date of allotment.

12. Maintain the Register of Sweat Equity Shares as per Format of the Rules as
S. No. Folio No. / certificate Date of passing of Date of issue of
No. resolution sweat equity shares
1 2 3 4

Name of the Status of the allotteeReference to entry Number of sweat

allottee - whether director in register of equity shares issued
or employee members
5 6 7 8

Face value of the Price at which Total consideration Lock in period till
share shares issued paid by which date
employee/director
9 10 11 12

13. Where shares are allotted as per the Unlisted Companies (Sweat Equity Shares) Rules, 2003,
the Board shall place before the annual general meeting a certificate from the auditors of the
Company or PCS that sweat equity shares have been allotted in accordance with the
resolution of the company in the general meeting and these Rules.
14. Issue at Consideration other than cash: Where a company proposes to issue sweat equity
shares for consideration other than cash, Company shall comply with following :

(a) The valuation of the intellectual property or of the know-how provided or other value
addition to consideration at which sweat equity capital is issued, shall be carried out by a
valuer;

(b)the valuer shall consult such experts, as he may deem fit, having regard to the nature
of the industry and the nature of the property or the value addition;

(c) the valuer shall submit a valuation report to the company giving justification for the
valuation;

(d)a copy of the valuation report of the valuer shall be sent to the shareholders with the
notice of the general meeting;

(e) the company shall give justification for issue of sweat equity shares for consideration
other than cash, which shall form part of the notice sent for the general meeting; and

(f) the amount of Sweat Equity shares issued shall be treated as part of managerial
remuneration for the purposes of sections 198, 309, 310, 311 and 387 of the Companies
Act, 1956 if the following conditions are fulfilled:
i) the Sweat Equity shares are issued to any director or manager; and,

ii) They are issued for non-cash consideration, which does not take the
form of an asset which can be carried to the balance sheet of the company in
accordance with the relevant accounting standards.

15. Accounting policies:

(a) Where the sweat equity shares are issued for a non-cash consideration, such non-cash
consideration shall be treated in the following manner in the books of account of the
company:

i) where the non-cash consideration takes the form of a depreciable or

amortizable asset, it shall be carried to the balance sheet of the company in
accordance with the relevant accounting standards; or

ii) Where clause (a) is not applicable, it shall be expensed as provided in

the relevant accounting standards.

(b)In respect of sweat equity shares issued during accounting period, the accounting
value of sweat equity shares shall be treated as another form of compensation to the
employee or the director in the financial statement of the company.